Trailer Park Toronto

“There is a sucker born every minute” PT Barnum

Recent events in Toronto must be causing David Pecaut, to spin in his grave.

Over the past few months the legislative agenda at City Hall has imploded, throwing the political process into turmoil and imperiling the budgetary and planning imperatives. This ongoing political circus was temporarily upstaged by the Donald Trump circus, which moved into town briefly last week for the grand opening of the Trump Hotel and Condo Tower; a garish and undersold property development at the corner of Bay and Adelaide.

We then were treated to a story in Toronto’s tabloids about the owner of the Bunny Ranch bordello in Nevada declaring his intentions to expand his business into Canada.  Sixty-five year old, Dennis Hof, together with his business partner and pneumatically-gifted paramour, Cami Parker (twenty-five), told the papers in part that his establishment aimed for Toronto, will allow patrons to “dress up as Captain Kirk and play with Princess Leia.” Perhaps. But to me the thought of someone more than ten years older than me calling a woman that is younger than my oldest daughter, his “girlfriend” leaves me more than a little weirded out. Isn’t the general rule for these type of age-difference relationships “half your age plus seven years”?

No matter, the trailer park theme moved into absolute top gear when the issue of allowing Casinos into the City was again raised by a number of City councillors. Coincidentally, one of the casino supporters was past brothel-booster Giorgio Mammoliti who said that “Single mothers could hit the jackpot” with a Toronto Casino. Appearing as a guest on Mayor Rob Ford’s Newstalk 1010 show, Mammoliti floated the idea that a casino in Toronto could create “10,000 jobs” for residents. The idea appeared to get additional legs when “opinion surveys” of dubious provenance were trotted out to demonstrate that a small majority of Torontonians were in favor of the casino idea. Some councillors have even gone so far as to advocate extending tax breaks to Casino operators in order to attract them to Toronto.

The reasons why local politicians want to expand gambling as a form of industrial and jobs initiative is understandable on one level: Any new initiative which brings with it the allure of thousands of new jobs, expanded tax revenues and economic development can give the appearance of economic salvation. However, the degree to which this motivation is being exploited by gambling interests and their supporters and to where this could lead if the issue was left un-evaluated on its true merits is a serious matter that should concern all Canadians, and not only those residing in Toronto and environs.

Until recently, most research on the effects of gambling on local economies was conducted by special interests friendly to the gambling industry; or, in more brazen cases, by the very people and gaming companies in search of new places to exploit people through the legalized gambling mechanism. In fact, in 1999 the United States published a very comprehensive study of legalized betting in the United States. The Gambling Impact Study called for more research into what was then the largely unexplored area of the social and economic costs of legalized gambling.

Since then, a large body of evidence and data-based research has been established on the basis of years of experience with legalized gambling in the US, Canada and elsewhere which addresses in detail what the social costs and second order effects are, and why it is important not to just consider the jobs and spending parts of the equation in isolation.

Increased Bankruptcies

For example, with the exception of the cluster services associated with gambling, casinos tend to put pressure on surrounding businesses. In Atlantic City and elsewhere, small business owners testified to the loss of their businesses when casinos came to town. As evidence of this impact, few businesses can be found more than a few blocks from the Atlantic City boardwalk. Many of the “local” businesses remaining are pawnshops, cash-for-gold stores and discount outlets. One witness noted that, “in 1978 [the year the first casino opened], there were 311 taverns and restaurants in Atlantic City. Nineteen years later, only 66 remained, despite the promise that gaming would be good for the city’s own.”

In another example, bankruptcies in Iowa increased at a rate significantly above the national average in the years following the introduction of casinos. Nine of the 12 Iowa counties with the highest bankruptcy rates in the state had gambling facilities in or directly adjacent to them. After gambling was legalized in South Dakota, gambling become one of the leading causes of business and personal bankruptcies.

Data from other US states is consistent with this general profile and the bankruptcy phenomenon also prevails in Canada, as these pictures of downtown Niagara Falls which were taken after the Casinos moved in, will attest.

Increased Crime

According to the US National Research Council, “As access to money becomes more limited, gamblers often resort to crime in order to pay debts, appease bookies, maintain appearances, and garner more money to gamble.” In Maryland, a report by the Attorney General’s Office stated: “[c]asinos would bring a substantial increase in crime to our State. There would be more violent crime, more juvenile crime, more drug- and alcohol-related crime, more domestic violence and child abuse, and more organized crime. Casinos would bring us exactly what we do not need: a lot more of all kinds of crime.” Another study found that gambling behavior was significantly associated with multiple drug and alcohol use.

In a Canadian study casinos were positively associated with both rate of theft and robbery. And a recent RCMP investigation conducted in British Columbia found legalized and other forms of gambling intimately connected with gangs, the Mafia, money laundering, prostitution, drug addiction, robbery and extortion.

Obviously law enforcement costs escalate in these situations

Corruption

Once gambling enters a community, it has been established that the community undergoes many changes one of which is that local government becomes “a dependent partner in the business of gambling.” Politicians end up being beholden to the gambling industry whether explicitly or implicitly. In recognition of the problem of corruption, in some US states, it is now illegal for officials to accept contributions from gambling interests.

Homelessness increases

Individuals with gambling problems constitute a very high percentage of the homeless population. The Atlantic City Rescue Mission reported to the Commission that 22 percent of its clients are homeless due to a gambling problem. A survey of homeless service providers in Chicago found that 33 percent considered gambling a contributing factor in the homelessness of people in their program. Other data also substantiate this link. In a survey of 1,100 clients at dozens of Rescue Missions across the United States, 18 percent cited gambling as a cause of their homelessness. Interviews with more than 7,000 homeless individuals in Las Vegas revealed that 20 percent reported a gambling problem.

But what about these high-paying Gambling jobs?

The reality is that there aren’t many “high-paying” jobs. After the initial fillip to the economy provided by the construction of the facilities, casinos are far more eager to place slot machines into the building rather than to hire and train thousands of dealers and other casino employees. This is because each slot machine can bring in $100,000 per year of revenue and doesn’t demand a sick day, benefits or overtime and needs only the occasional dusting for maintenance. Casino workers pay averages around $24-30,000, not “high-paying” by any stretch.

Moreover, recent Canadian research has shown that Ontario casino workers are at exceptionally high risk for developing gambling problems and the attendant side effects. Employees’ gambling behaviors were found to relate to various workplace influences and employment variables. Casino employees in Ontario interviewed in the study exhibited problem gambling rates over three times greater than those of the general Canadian population.

Gambling Addiction has been recognized as a clinical psychological disorder. Today, millions of families suffer from the effects of problem and pathological gambling. As with other addictive disorders, those who suffer from problem or pathological gambling engage in behavior that is destructive to themselves, their families, their work, and even their communities. This includes depression, drug and alcohol abuse, divorce, homelessness, and suicide, in addition to the individual economic problems discussed previously. While the impact of these problems on the future of our communities and the next generation is indeterminable, it is clearly much larger than zero.

If you are a single Mom, do you now still crave those jobs as Mammoliti suggests you should?

The Bottom line

Unfortunately, this is not where this sobering news ends. Research in the US indicates that for every dollar legalized gambling contributes in taxes, it usually costs the taxpayers at least three dollars. These costs to taxpayers are reflected in: (1) infrastructure costs, (2) relatively high regulatory costs, (3) expenses to the criminal justice system, and (4) large social-welfare costs. Another researcher, Professor Grinols, found that Casino gambling in the US causes up to $289 in social costs for every $46 of economic benefit. Put differently, Grinols said, “The costs of problem and pathological gambling are comparable to the value of the lost output of an additional recession in the economy every four years.”

Accordingly, several US state legislators have called for at least partially internalizing these external costs by taxing all legalized gambling activities at extremely punitive rates.

It is for all of the reasons enumerated above that Putin’s Russia outlawed gambling and casinos in 2009.

But aren’t Singapore and Nevada big success stories?

If there are all of these costs and negative externalities why is Singapore still a prosperous city-state with two mega-casinos located within its borders? Simple, this is because only foreigners can patronize casinos for free. Citizens and permanent residents must pay a $70 entrance fee or a $1400 annual pass to enter a casino. The hefty admission price, which is collected by the government, “discourages impulse gambling,” a Singapore official explained. To fill the casinos, promoters ferry in high-stakes gamblers, known as “whales,” from neighboring countries.

Nevada is also unique. Roughly 85 percent of Nevada’s gambling revenues come from out-of state tourists. Thus, Nevada receives the economic benefits of the dollars lost to gambling, while the attendant social and economic impacts of unaffordable gambling losses are inflicted on the families and communities in the states and countries from which those individuals come. Every gambling venue in Canada is far more reliant on spending by citizens in a far more concentrated geographic area and so would never be able to position itself to reap this kind of benefit unless it imposed Singapore-type disincentives on the local population (in which the case the known costs would still be inflicted on someone else, and more importantly the fundamental rationale gambling interests have for locating the Casinos in Canadian cities would evaporate)

A “destination gambling mecca” was never any part of David Pecaut’s vision for Toronto and it is hard to see how it is a part of any rational “vision” for the city or for Canada now or at any time in the future either. The promised benefits do not exist in the magnitudes advertised and are in any event significantly outweighed by the expected costs. Moreover, the predictable second-order effects of casino activity as described in the research are positively nightmarish.

Torontonians and all Canadians should not allow themselves to be buffaloed into a rash and unwise decision on this matter by the large-scale gambling interests and any venal, shallow-thinking facilitators that they might be connected with, and who are in positions of decision-making authority.

The facts are out there and it is time to consider them seriously.

Alex Jurshevski was intimately involved with the GBP 1500 MM acquisition of UK gaming company William Hill Bookmakers by Nomura International in 1997 and, far from being puritanical on the issue of wagering, is an avid poker, blackjack, bridge, backgammon and snooker player.

If anyone wants a full bibliography of the research material on which the forgoing article is based beyond the hyperlinks provided above, then please drop us a line.

Posted in Bankruptcy, Canada, Crminal Activity, Economy, Gambling | No Comments »

Ratings Agencies take Aim at Large Banks

Late yesterday the Moody’s Ratings agency announced that it was considering a downgrade of a number of Euro-zone, US and Canadian banks including Canada’s largest and arguably its most venerable banking institution, the Royal Bank of Canada (RBC). Readers might recall that Moody’s stripped the RBC of its Aaa rating in December 2010.

At the time this was not much of a surprise because the bank had been placed on negative credit watch earlier in that year largely due to an announcement by the RBC that it was seeking to generate a larger share of its total bottom line from Capital Markets businesses. The downgrade also occurred despite RBC having emerged from the Global Financial Crisis (GFC) relatively unscathed and in much better shape than most of its offshore competitors. Other agencies soon followed suit with their own downgrades for the bank.

The RBC is currently rated AA- by S&P and Aa1 by Moody’s. Fitch, and DBRS the other major agency and Canada’s domestic credit watchdog respectively, both peg the RBC credit quality at AA. Thus while the latest Moody’s announcement will bring their ratings assessment into line with their major competitor, it still remains above the credit assessment given by the two smaller agencies

The recent ratings action again pays reference to that fact that RBC’s announced business plans are running into strong headwinds, not in the least due to the furor over implementation of the Volcker rule, but also because the markets that it is seeking to exploit in the search for revenues are running into difficulties in the form of widening spreads, lower volumes, poor funding conditions and deteriorating investor appetite.

Other Banks under review for possible downgrades include Citigroup, Bank of America, Goldman Sachs, JPMorgan Chase and Morgan Stanley; and Moody’s said it is  extending its reviews on whether to lower ratings on Credit Suisse, Macquarie, Nomura, UBS, Barclays, BNP Paribas, Credit Agricole, Deutsche Bank, HSBC, Royal Bank of Scotland and Societe Generale. Moody’s also extended ongoing reviews for downgrades on 11 companies.

Pointing to regulatory, balance sheet and liquidity the agency said in a statement after markets closed last night: “These difficulties, together with inherent vulnerabilities such as confidence-sensitivity, interconnectedness, and opacity of risk, have diminished the longer term profitability and growth prospects of these firms”.

The Moody’s news came hard on the heels of credit downgrades for a number of Euro-zone countries including Italy, Portugal and Spain because of uncertainty over the weakening profile of economic activity in Europe and a growing credibility gap regarding the advisability of the polices being forced on debtor countries by the EU/ECB/IMF “Troika”.

Do these Announcements now make the World now “Safer” from Financial Calamity?

Nothing could be further from the Truth.

In our opinion here at Recovery Partners, this latest wheeze from the Ratings Agencies is comparable to the fevered activity of Balinese pool boys trying to rearrange deck chairs in the middle of a force-5 Typhoon.

While EU leaders have droned on for the last several years about their intentions of putting a “firewall” around the banks and nations most afflicted by the euro zone debt crisis, nothing of the sort has occurred. In fact, the recent Long Term Refinancing Operation (“LTRO”) in Europe and ongoing easements in collateral rules make a massive outbreak of contagion more likely rather than less likely because, systemic risk is increasingly becoming a function of the credit quality of the weakest banks, rather than the strongest banks. The ratings agencies’ recent focus on the stronger banks such as the RBC only serve to underscore the  point that these announcements are largely a sideshow.

As we know, mark-to-market rules have either been overtly suppressed by regulators in Europe and North America or ignored.

In fact, given the unrelenting stresses in the interbank markets in Europe and elsewhere, we are wondering whether or not we are close to an explicit “event of diktat” similar to what was recently announced by the Chinese authorities. Not widely publicized, a particular example of how bad things are is given by China, the authorities there have recently commanded the banks to roll over maturing loans to local authorities in full knowledge that they are non-performing and cannot be, and will not be, paid back even under the rosiest of scenarios because they are backed by asset positions that are largely worthless and non-income producing. In the wake of the GFC, Chinese Banks lent the equivalent of 25% of Chinese GDP to local authorities. This is not a small problem.

Having the central government tell the Chinese banks to represent (to the regulator controlled by it no less!)  that the loans are sound will not make them pay off nor reduce the eventual chop that the banks will have to take. This subterfuge only postpones the inevitable day of reckoning and contributes to further uncertainty.

A notch or two on RBC’s rating or on the ratings of similar banks is hardly an issue that anyone  should lose sleep over in the current environment. There are much, much bigger demons out there.

Posted in Bank Loans, Banks, Canada, Crisis, EU, Regulatory, Sovereign Debt, USA | No Comments »

The “Restructuring Deficit”

Financial Repression is being implemented by Monetary and Financial Authorities in many developed economies. The specific measures range from overt manipulation of traded markets, acquisition of toxic assets at off-market prices, an aversion to implementing needed restructuring of bankrupt entities, through to indirect forms of intervention such as we are witness to in Canada. The short term consequences of these types of policies include restraining economic growth, employment and productivity. Longer term consequences include inducing a greater predisposition towards inflationary policies by the monetary authorities, loss of competitiveness, moral hazard, below potential GDP growth and depressed rates of capital formation.

The Canadian Experience

In Canada so far our Central Authorities have refrained from overtly intervening in markets as noted above. That job has been left to the Crown Corporations. The Economic Action Plan announced in 2008 provided the Crowns with additional capital and a mandate to use that capital to support Small and Medium sized businesses in Canada (SMEs). Since then the Crowns have made no secret of their extended mandate.

Thus, one need not look far to find evidence of this “stealth bailout”. In Canada we have seen rapid increases in personal bankruptcies that mirror the weakness in the jobs picture and the cost-cutting efforts of many firms desperate to remain in business. Also, the number of personal bankruptcies has escalated rapidly, consistent with the scale of job losses in the early stages of the GFC. However, on the business side of the coin, the situation in Canada reflects the perverse nature of this stealth bailout. This is the fact that since the onset of the GFC the business bankruptcy statistics are not telling a tale of undue financial stress. In fact, the latest twenty four months of data show that the incidence of corporate failures in Canada has actually gone down! The data show that there were 38% fewer bankruptcies coast-to-coast in the year to October 2011 than  2007 just prior to the GFC.

The “Pig in the Python”

At the same time according to the chart, at the peak in 2010 there waa an almost foufold increase in Gross Impaired Loans (GIL) in Canada. In 2011 the GIL numbers were still almost three times higher than in 2007 and prior to the GFC. Yet, corporate bankruptcies have gone down! Moreover, if you speak to them most insolvency professionals report that business has been at it lowest ebb that they have seen over their entire careers! A number of Canadian restructuring firms have sharply cut back staff, gone out of business or have otherwise greatly curtailed their operations. Per the above-noted chart the chief cause is that the banks are not reprocessing their NPL assets in a manner consistent with past cycles and have instead been exercising extreme forbearance.

The bottom line is the fact that a large volume of restructuring that would have normally been expected to occur on the wake of the Global Financial Crisis (GFC) in 2008/2009 has simply not occurred.

Quantitative Analysis

The statistical records on corporate failures in Canada that have been maintained by the Superintendant of Bankruptcy extend back almost sixty years. The behavior of this time-series is akin to that of a step function. Historically there has always been a sharp increase in the incidence of corporate failure in the immediate aftermath of an economic slowdown or recession. This relationship has held up through numerous cycles up to, but not including the GFC. And, in looking at past cycles, the increase in the failure rates on a twelve month moving average basis was at times as high as 60% peak to trough.

The past decade has seen three distinct phases of restructuring activity in Canada. Between 2000-2003 in the wake of the Telecoms, Internet and Media bust, Canadian banks resorted to bulk sales to divest themselves of unwanted assets and distressed files. Two of the more motivated banks in this regard were CIBC and the TD. Then, between 2004-2007 the bulk of off-strategy and distressed files  were pieced out by way of bilateral loan sales to leveraged loan funds that were relatively credit and price insensitive. Both of these periods saw significant levels of activity where banks were actively repositioning credit risk in their portfolios. Following that and since 2008, and up to the present, there has been very little activity despite a sharp run up in Gross Impaired Loans balances. There has been a corresponding lack of activity in business failures and active restructuring of loan files.

To examine the history further we have used three quantitative approaches to estimate a possible shortfall in the number of business failures that have occurred since the GFC:

The first test we ran tested the null hypothesis that the distribution of failures before the GFC had the same statistical properties as the distribution of failure events following the GFC. The results here show that it is not possible to reject the hypothesis that the distributions are different. This provides some statistical support for the contention that we are in a different behavioral phase with bankruptcies and corporate restructuring in Canada now relative to what went on before the GFC.

We then used two other methods to drag some more information out of the data set. The objective of both tests was to try and determine if the level of business failures that we have experienced in Canada since the GFC is “unusually low” and is so by how much. In summary this exercise suggests that there is at present a “restructuring deficit” of between some 6,000 and 13,000 businesses that could have been expected to have gone bust in the last three years but did not (This translates into between approximately one-half to one percent of all SME businesses in Canada). Translating those figures into potential monetary exposures Recovery Partners estimates that there are at least $20 to $30 billion of loan-related charge offs and or restructuring candidates that are bottled up on chartered bank balance sheets and elsewhere.

Zombie finance works only once. At the time this strategy was implemented the expectation was that the significant stimulus that was pumped into the economy would have resulted in a fairly rapid pace of recovery. In turn this would have refloated the businesses that were underwater allowing them to return to profitability and pay down their debt. This clearly has not happened. And, it is unlikely that the old zombies will be able to pull off another rescue financing particularly if the economy continues to grind along at a low rate of expansion or if it falters and maybe another downturn works its way into the mix.

A Rising Default Environment

A number of macro-economic factors affecting credit markets worldwide, including in Canada, suggest that all credit markets are entering a rising default rate environment. Both US and Canadian consumers are beginning to exhibit substantial signs of spending fatigue simultaneously with a significant, and accelerating, renewed softening of residential real estate markets in the US — the source of a substantial portion of consumer spending and employment growth in the last decade. Moreover the widening crisis in the Euro zone has already knocked EU growth for a loop as a recession is now expected there. The inevitable contagion will likely lead to confidence problems in North America as well threatening a more protracted slowdown here as well.

Therefore, for the banks, time is running short. Further cracks are appearing in the banking system and the economy and the authorities cannot stop them from spreading. In fact our views on the Stress Tests reflect the opinion that the problems in the banking system are far from having been properly resolved. In the US, in aggregate, banks remain significantly undercapitalized. Moreover, numerous US Banks that have earlier qualified for TARP funds now have more toxic (Level 3) assets on their books than before the financial crisis began. Other areas of concern include credit cards, commercial mortgages, and of course the fact that anecdotal and other evidence continues to reflect an anemic US economy whose consumers are tapped out and who have either fallen into unemployment or under-employment in vast numbers, where a substantial portion of the housing stock is under water, and whose Government is in a deepening fiscal hole.

In Canada, the situation may be even riper for a downturn in the credit cycle, especially in the export sector. The Canadian dollar has appreciated against the US dollar by more than 40% substantially eroding profit margins for Canadian exporters. For many of the banks as well, it is a case of “they do not know what they do not know”. Quite simply this means, that because of the distortions caused by zero interest rates, the lax forbearance practices and easements in lending covenants and loan servicing, many banks cannot today reliably identify all of the zombies and at-risk obligors in their portfolios. There is thus a substantial recognition lag built into the required solution to this problem.

Should the economy slow from here or enter a recession, institutions that hold large quantities of bad or deteriorating credits that have hitherto been slow in dealing with these exposures will find themselves competing against each other to unload or otherwise cope with these problems. Moreover, to existing exposures we have to add the new zombies that will have gone to ground because of continued weakness in overall activity.

This article is an abridgment of a longer research piece written by Alex Jurshevski, Managing Partner of Recovery Partners with research assistance from David R Fine, Director Credit Asset Management at Recovery Partners and appears in the January 2012 edition of Canadian Hedgewatch

Posted in Bank Loans, Bankruptcy, Banks, Canada, Crisis, Loan Losses, Restructuring, USA | No Comments »

The Canary in the Coal Mine – Part I

“Now if I tell you that you suffer from delusions; You pay your analyst to reach the same conclusions; You live your life like a canary in a coalmine; You get so dizzy even walking in a straight line”

Sting and The Police

Monday’s news of the failure of the debt ceiling negotiations in the US ahould not have come as a surprise to anyone who has followed this issue. Disheartening, sad, and ultimately dangerous to our economic well-being and Global Stability, yes, but unexpected, no. Recovery Partners was interviewed on that very topic yesterday and the full interview is avialable here in part 1 and part 2 or you can watch an abridged version on our site.

On Monday  Zerohedge posted a note on Austria, entitled “35 Seconds Of TV Air Time Explaining Why Austria’s AAA Rating Is Doomed“. Most of the discussion focused on the massive Central and Eastern European credit exposure. According to them, massive bank credit losses and a sovereign downgrade is a sure bet as well as the fact that contagion has spread to several Central and Eastern European economies.

Elsewhere on the Continent, the Sovereign obligations of Eurozone countries were getting smoked as spreads against German bonds blew out across the board.  Looking ahead at the heavy borrowing calendars for many of these countries the picture does not look good.

In related news, European stock markets dropped Tuesday after an expensive bond auction for Spain and as data showed that the U.S. economy grew at a slower pace in the third quarter than initially estimated.

Also today, IMF Managing Director Christine Lagarde said in an e-mailed statement to accompany a press release annoucing the creation of a new IMF fast-track liquidity facility. “This is another step toward creating an effective global financial safety net to deal with increased global interconnectedness.”  It is no surprise as these announcements came as Europe’s crisis threatens to spread to Spain and France. The real “non-announcement” here is that this is happening because the Euro-people have yet to implement the Bailout plans agreed to weeks ago in part because the EFSF has become non-functional and incapable of producing needed funding for cash-starved Euro-governments. This despite the recent publicly announced intentions to ramp up the EFSF to between EUR 1 and 2 Trn. How ironic it is that just over a year ago on the establishment of the EFSF, that Olli Rehn, EU commissioner, boasted that the EFSF would “never need to be used”. Now it is obvious that, apart from some half-completed bailouts, it has proven to be of extremely limited effectiveness and can no longer function.

And earlier this morning it was reported by the FT that the Chinese Banking Regulator (the CBRC) announced that the Chinese Property slump exceeded the test limits of the Chinese bank stress tests. In April, the CBRC told banks to test their loan books against a 50 per cent fall in prices, and also a 30 per cent fall in transaction volumes. In October, however, property transactions fell 39 per cent year on year in China’s 15 biggest cities, according to government data. The weaknesses in the Chinese scenarios echo earlier problems with stress testing in the EU, where regulators underestimated the potential impact of a sovereign debt crisis.

Joining the party, the Fed announced new stress tests for the top 19 US banks to take place between now and January and having the results announced by March 2012. There are six large banks that are going to attract particular focus according to the Fed press release and accompanying statements.

Watch this space.

Early Warning Systems and all That

During my time in New Zealand I remember seeing lorry loads and trainloads of sheep, cattle and pigs being packed off  to the slaughter houses and knacker’s yards. Over the time I was in that beautiful country, I observed the behaviours of these animals as the transport vehicles rumbled past and this left me with the indelible impression that these creatures somehow knew that something ominous was afoot….even though they could not read, write or understand a sentence of English, much less the road map.

 This brings to mind the OWS movement which appears to have swept the globe as a phenomemenon that defies definition. The OWS movement seems a jumble of contradictions: it professes respect for the enviroment but its activities have destroyed parkland and befouled inner cities with garbage and human waste; it professes respect and fellowship for citizens of the countries in which it staging its protests, yet it’s activities have significantly interfered with the commercial interests of small businesses and their employees, threatened passersby with violence and has otherwise commanded the attention of our law enforcement authorities to the deriment of others who might actually have benefited more from their attention at a particular time; and yet all along it professes to be able to “see the future” and is therfore justified in attempting to change that “fate” for everyone’s benefit. Moreover, in conversation, not one of the OWS protesters has been able to articulate a coherent vision, objective or group mission that all OWS protesters can agree with.

 The ultimate irony of the OWS “movement” however lies not in the paucity of substance, it lies in the fact that what little substance its demands and prescriptions contain, all seem to feature demands for exactly the wrong thing. This is quite simply that  the common thread among OWS protesters is that they are screaming for : more Government, more state control, more handouts, and generally speaking, for the Government or some other central authority to “solve” their problems. This is precisely the wrong prescription delivered at a time when the reality is that the cause of many of our challenges today is that the modern Welfare State has run out of rope, our political structures have not responded well to recent challenges and, combined with the demographic picture, that there is simply is no more “wealth” to be “spread around”. The choices Western society confronts today all revolve having to make do with less. That is the Bottom Line that the OWS is ignorant of at a fundamental level.

This “movement” in its present state will therefore likely fade away shortly and none too soon. Although the OWS folks sense that “something is wrong” in the world, they, like the animals on the way to the slaughterhouse, cannot articulate what it is they sense and fear, and, because of that and other inherent limitations, they are in no way equipped to devise strategies or action plans to avoid whatever fate awaits them, nor by the same token, to be able profess that they can render such advice to anyone else.

Given the present unsettled state of the world the real issue for clear-thinking people is: “What comes next after these “occupiers” fade into the sunset?”

For more on that, please dial in to Part II of our Canaries Blog series in 24 hours.

Posted in Bond Market, Canada, Crisis, Crminal Activity, EU, Fed Policy, IMF, OWS, Sovereign Debt, USA | No Comments »

Greeks ‘R Us

“Money for nuthin’ and checks for free” Dire Straits

While the world’s attention this week has been focused on the sovereign debt crisis in Europe, a time bomb planted much closer to home has continued ticking away, yet it is virtually unnoticed. That problem is the massive debt piled up by American state and municipal governments over the past several decades.

Lavish spending on social programs together with an unwillingness to even consider raising new revenues means a number of American states, most notably California, are heading down the same road as Greece and other European countries. Social programs such as EBT, which are richly satirized in this video, combined with the pillaging of the state treasury by the public sector unions have resulted in the impending bankruptcy of America’s largest state.

And nobody seems to care.

California is governed by, and for the benefit of, it’s elected and other public officials. The State legislature has gerrymandered itself into highly partisan electoral districts where the incumbents for each party are safe. They each play up to their base; the Democrats by buying people off with taxpayer dollars, and the Republicans by refusing to raise taxes in any circumstances. So everyone gets re-elected while the state slides inexorably towards bankruptcy.

Today, in 2011, the average Californian has debts of $ 78,000, and an income of $ 43,000, so blowing borrowed money is normal to them. Similar to Greece this virtual bankruptcy of the state is not a temporary situation brought on by a recession or a blip in economic activity. It is institutionalized. It is built into the way Californian power brokers run their state. It has become standard operating procedure. Overspending, openly bribing public sector unions with ever more generous pay and benefits, and refusing to raise new revenues in any and all circumstances, is the “new normal” in sunny California, home of the original Fantasyland.

As Michael Lewis points out in his new book “Boomerang”, California will spend $32 billion dollars on pay and benefits this year, up 65% over the past 10 years. Meanwhile education spending is down 5%, and health and human services payments are up only a scant 5%. Here are some example of the insanity: In California a prison guard who started his career at age 45 can retire after 5 years with a pension nearly equal to his salary. The head psychiatrist for the California prison system makes $838,706. In the meantime the state’s share of the budget for the University of California has fallen from 30% to 11 %. Tuition at the University of California has gone from $776 in 1980 to $13,218 today. “Everywhere you looked the long term future of the state was being sacrificed”, according to Lewis.

Governor Schwarzenegger tried to change things. He thought he had been given a mandate to do so. He tried working with Republicans. No dice. He tried working with Democrats. Nothing doing. He tried to sweet talk, he tried to cajole and he even tried to bully them. Nothing. So he then tried going over their heads to the people directly in a special election based on four reforms: limiting state spending, putting an end to gerrymandering of the state electoral districts, limiting public employee unions spending on elections and lengthening the time it took for public school teachers to get tenure. All four were defeated by sizeable majorities. Toward the end of his second term Governor Schwarzenegger finally managed to pass a slight tax increase by persuading four Republicans to help him create the supermajority necessary to pass the measure. Californian voters thanked these four brave souls by promptly defeating every one of them in the next election.

Closer to home things are not much better in Ontario. Over the past eight years the McGuinty government has so mismanaged Ontario’s finances that Ontario now has a budget deficit of almost $17 billion dollars and has increased the provincial debt by $100 billion to $ 235 billion. This was quite a feat considering that McGuinty created new taxes one after another and raised other existing levies.

Apparently, nobody in public life in Ontario believes that the McGuinty’s Liberal government debts will ever need to be re-paid. In last month’s provincial election barely a word was uttered by anyone about deficits, debt, and the manner in which the onus of re-payment can strangle an economy. Friday’s job loss figures in Ontario’s manufacturing sector is but one indication. Even the ostensibly “free market” Ontario PCs never mentioned that there might be a need for Ontarians to live within their means, for fear of frightening voters with the revelation that Ontario might not be able to borrow and spend in perpetuity.

As events in Greece have proven, democracy only works when citizens act in an informed and responsible manner in the best interest of the community as a whole. Grabbing as much as you can get and sticking someone else with the bill has not been a recipe for long term success. The combination of self serving and cowardly politicians and an uninformed and demanding public that insists on living in a world of make-believe in places like California and Ontario will have devastating consequences for anyone hoping to receive even basic public services in the very near future.

The recent speech by Edmund Clark, Chief Executive of the Toronto Dominion Banking Group is a laudable attempt by one of our most respected business leaders to bring these issues into sharp focus. It would be encouraging if more of our business and political leaders were to pick up on this message and become prepared to throw their weight behind a movement towards awareness and appropriate reform designed to create a sustainable fiscal path for our economy. There is literally no time to waste in trying to turn this state of affairs around, we are living beyond our means and there are no painless solutions.

Do Canadians want to see their future generations suffer from our legacy of profligacy or are we going to make the hard choices necessary to turn back the tide of self interest and greed in order to ensure that we avoid driving our society into the ditch?

If we allow the unthinkable to happen, we will only have to look in the mirror in order to see who is responsible for our miseries a few short years from now.

This Blog was written under the pseudonym of “Caol Isla” whose professional qualifications include the practice of law, two stints in the Prime Minister’s Office, Chief of Staff to two Cabinet Ministers and to two Leaders of the Opposition in Ottawa, comprising a total of 34 years of service at senior levels in the Federal Government and public affairs in Canada.

Posted in Canada, Crisis, EU, USA | No Comments »

The Brazil Trade

Quis custodiet ipsos custodes? (Who guards the guardians?)

Juvenal

It all seems to be coming down to the wire: Slowdwn in the US and Europe, downgrade of economic propects in Canada; Greece on the brink of default and financial contagion feared as a consequence. Since the onset of the Global Financial Crisis (GFC) the markets have repeatedly received asurances from the authorities that the situation was containable and under control and that the policy path set by them was appropriate. Now it seems that these assurances were misplaced. Where did it all go so horribly wrong?

The “Brazil Trade” was a joke scenario that was bandied about on many of the trading desks that I have worked on in years past. Basically the story goes as follows: you pick your trades ahead of a set of economic releases, do them in huge size and with leverage, and then buy a one-way ticket to Rio de Janeiro and go to the airport. Leave one of the traders on the trading desk to watch the screens and the blotter. After the numbers release, you phone your desk from the airport to find out what happened (yes, this storyline involves communications technology that pre-dates the Blackberry, I-Pads, and proliferation of digital news screens). If your positions go onside big time, then you leave the airport go back to the desk in anticipation of a big bonus payout, and life continues as usual. If, alternatively, you blow up, you get on the plane and live off of your previously accumulated pelf in moderate confort on the beach in Rio. (The Nick Leeson / Barings debacle in 1994 was a criminal variant of the Brazil Trade that involved a luxury yacht.)

The bottom line of the Brazil Trade is thus simple: if you win the low probability bet; you win really big and life goes on as before and is even better; if you lose, life as you know it is over because you are now a fugitive living in purgatory.

Any prudent banker or trader knows that you need to blow the bad deals and bad trades out of your portfolio before the next cycle of profit making starts. However, the entire approach to crisis management in North America and Europe over the last three years has been to attempt a short circuit of this process and to foist the impression on the markets and the public that no reckoning or adjustment was or is needed in order for life to go on as before.

And, in implementing this vision of the way out of the crisis, vast amounts of taxpayer dollars have been put at risk.

Now the strategy is starting to fray in earnest. In Europe political support for the bailout strategy is faltering, Germany appears to be positioning for Greek default, while the other peripheral countries slip closer to the edge and major banks’ share prices plummet – short selling ban or no. The resignation in the last few months of two senior ECB officials – Juergen Stark and Axel Weber (note: Weber was the heir-apparent to Trichet over Draghi) – signals deep policy divisions at the Central Bank. For the policy hawks unfortunately, these two resignations represent a victory of the bailout-supportive policy doves and, most likely, a continuation of present ECB policies.

In the US the latest wheeze in the form of the Obama Jobs Plan signals just how far removed from the reality of the markets the policymakers and politicians there are. What of the recent bust up over the debt ceiling and the stated need of the Debt Reduction Super Committee to find $4 Trillion in cuts before the end of 2011? Apparently this does not matter any more – $450 billion will be spent on extending unemployment benefits and other transfers before consideration of the funding mechanism is settled. More fundamentally, in our opinion the whole package boils down to a “potluck” policy grab bag that can only incentivize the unemployed in the US to stay unemployed. If passed by Congress, it will not achieve anything meaningful outside of an increase in the US Federal debt.

Canada is not immune. Not only are our debt levels very high by international standards, the can has been kicked down the road by the authorities here while our economy remains vulnerable to accelerating slowdowns in the US, Europe and China. There should be no question, but that the de-risking of the economy here from exposure to another major credit event must be a policy priority. For the avoidance of doubt we are not advocating more stimulus (in fact the very opposite) but more active risk management of the Zombie situation and more predictable control over government finances at all levels of public administration.

We are in this unfortunate situation because the authorities in North America and Europe never encouraged the markets to make the needed adjustments three years ago. Had they let the markets find a solution and refrained from meddling:

 The eventual price tag would have been lower and much more predictable,
 Inflation risks would be less,
 Unemployment would be lower,
 The number of sovereign, corporate and banking zombies would be MUCH LOWER,
 Sovereign debt burdens would be MUCH LOWER,
 The risks of an uncontrolled debt deflation and credit market collapse would be MUCH LOWER,
 The economies of America and Europe would be recovering.

The rapidly escalating crisis has swept the outcome of last weekend’s G-7 in Marseilles into the dustbin along with the sports pages and classified ads. This week we have more policy and political meetings in Europe; and next week we have the Federal Reserve Open Market Committee in a two day meeting down on L Street. The markets are now saying a Greek default is inevitable, other countries and buisnesses are edging closer to the precipice and yet the policymakers continue to bang the same drums.

Is anyone packed for a long trip?

Posted in Bank Loans, Bankruptcy, Banks, Canada, Crisis, Crminal Activity, EU, Fed Policy, Loan Losses, Sovereign Debt, USA | No Comments »

Bribery and the Board

Posted in Canada, Crminal Activity, EU, Insurance, USA | No Comments »

Money for Nothing and Checks for Free

“Those whom the gods wish to destroy they first make mad.”   Anonymous Ancient Greek Proverb

Wow, what a crazy week. About everything that could happen did happen, except for the delivery and signing into law of a credible deficit reduction and debt control plan by the American Legislative and Executive Branches.

In the wake of that failure, investors in the US Dow Jones index rewarded President Obama on the marking of his first half century of walking on this planet by shaving 500 points or almost 5 % off of that stock market gauge. By the end of the week global bourses had shed around $2.5 Trillion of value.

The debt ceiling debacle wasn’t the only motivator behind the gloomy sentiment weighing on markets:  renewed fears that the global economy might be entering a double dip were fanned by weak purchasing reports from Germany, flattish consumption-related and employment numbers in North America, and growing doubts about the fiscal sustainability of the debt-laden laggards in Europe, now to include, most notably, Italy.

On Friday the markets looked set for another big dump following weak employment readings announced early in the  day by the US Labor Department. It is unmistakable that some foreknowledge of the reduction in the S&P US long term debt rating that was announced following the market close was given to the US Government. Therefore it is our surmise that the Plunge Protection Team swung into action to prevent another swingeing setback following on the heels of the 500 point plunge the day previous. Thus,  after a wild intraday ride, the Dow closed on a dead cat bounce, up 61.

These events prompted G-7 and G-20 country governments to convene a set of emergency consultations over the course of the weekend to discuss measures to combat the malaise sweeping global markets and to contain any contagion effect from exacerbating conditions further. The price action on several markets so far today does not engender optimism for a placid trading week ahead.

With the apparent exception of the United States and a few people here in Canada (see below) a growing realization that fiscal stresses in Western economies mean that Government spending needs to be cut back, entitlements need to be cut back, and Government generally needs to right size and reconsider its role. The bottom line is that the social safety net has become too expensive and people need to be made more reliant on their own efforts rather than rely on handouts from Governments.

It is in this context that we read an article last week in the Financial Post entitled “Only More immigrants can save Canada’s Economy” . In this piece, the author, who is associated with the New Frontier Institute, contends that in order to “save” Canada’s pension system that we need to allow immigration to reach a million people per year as an urgent  matter of policy.

What claptrap.

 Nowhere in this article is it mentioned that Canada does not have the capacity to admit that many immigrants into the country. In the last five years the amount of annual jobs growth has been well below 200,000 per annum. Where and how are we going to employ these immigrants? What of the strain on our already overstressed medical, educational and public security infrastructures? No mention. Yet the author makes reference to a recent speech by the Minister of Immigration, Jason Kenney that does clearly spell out all of the constraints and considerations involved in setting immigration policy.

Arctic Circle Cartoons 

What of recent studies that demonstrate that Canada’s immigration policies admitting as they do a few hundred thousand folks per year actually cost the public purse significant money? This is given short shrift. Ivory Tower schemes are suggested to hand over immigration policy to the provinces, magically reduce the cost of admitting immigrants and to assume away the host of logistical and social challenges implicit in this proposal, all in the name of ensuring that Canada can “fund the Baby Boom generation’s retirement obligations.”

And what of the political and social implications of such a policy? Namely that, if implemented, within one generation we effectively would be handing over electoral control of our entire country to a demographic that has no long term  relationship to this place. In exchange for what? A pension bailout that benefits a narrow slice of the population, much of which is quite well off without Government help.

The reality is that the pension deficits are real. Most pension funds are insolvent in Canada, and therefore this is a problem that requires urgent attention. The reasons for these deficits are many. Some reasons include faulty design, poor management, venal politicians agreeing to over-rich settlements with public sector unions, bad luck or bad markets, theft, fraud, perverse incentives, or the fact that some plans ail from all or a subset of the foregoing impairments. None of this however means that they should be bailed out. This makes no sense, particularly in the context of what we already know to be the case of the retirees at Nortel, Enron and numerous other companies that failed to provide safeguards for the pension obligations they had to  their retiring employees. The reality is that in any conceivable context, the prudent, economic, legally and morally correct course of action is to write down benefits in order to meet the resources extant within each of these funds and share them out to the retirees. There can and should not be a bailout unless we intend to become the next Argentina or Venezuela.

 No doubt pension reform is a large problem and one fraught with political and economic risks. However throwing away Canada’s entire future to try and paper over mistakes made by the same ”Baby Boomers” that this writing suggests need help is pure madness.

 The New Frontier website lists a number of prominent people as being part of their Advisory Board, among them Ruth Richardson, former Minister of Finance in New Zealand;  and Sir Roger Douglas, the architect of the economic reforms in New Zealand that served as a blueprint for leading the country out of the abyss of subsidies, government interventions and meddling that caused the catastrophic meltdown there in 1984. At the same time, the website is extremely coy about where it receives its funding from, leading us to surmise that it may be acting as a shill for a set of vested interests that want to bias public policy in favor of themselves rather than proposing policies that make long-term sense for Canada as a whole.

I worked under Ruth when I was managing New Zealand’s Sovereign Asset and Liability portfolios in the mid 1990’s and I have met Sir Roger a number of times. The prospect that Ruth or Sir Roger would endorse the policy recommendations as spelled out in the New Frontier article, and in the context of the commentary we provide above and as reflected in Minister Kenney’s recent remarks, is in my opinion a very low probability outcome unless there has been a massive sea change in how they view the role of Government and the constituents of effective policy. If the New Frontier Institute believes that this is not the case, we invite rebuttal, accompanied of course by the math that supports the “million immigrant a year” proposal.

 Who knows what the future might bring? Flush with a majority Government and a five year term in office ahead of him, shamefaced clarion calls for bailouts of their entitlement programs by special interests may be setting up Stephen Harper for his very own “Scargill Moment”.

Posted in Bankruptcy, Canada, Crisis, EU, Fed Policy, Restructuring, Sovereign Debt, Stock Market, USA | No Comments »

Zombie Banks, The FDIC and Directors’ and Officers’ Insurance Premiums

Those who cannot remember the past are condemned to repeat it.” George Santayana

There is a direct connection between the banks, legislative changes and directors’ and officers’ insurance premiums. Relaxation of regulation and poor policies and procedures intensified and increased the losses associated with the S&L Scandal of the 1980’s and early 1990’s. But just enough time passed since then to give decision makers the excuse to forget the lessons learned from that sorry episode. Not surprisingly all of the same issues have resurfaced prior to the onset of the Global Financial Crisis (GFC) thereby contributing to the causes of the GFC and importantly to the failure of US Banks so far and the extremely weakened condition of the entire banking sector.

The FDIC provides a chronology of S&L events on their website, and in a book,. These should be made mandatory reading for every employee of every bank, insurance company, rating agency, securities dealer, accounting firm and law firm. There are at least of few people in every level of a company who can smell a problem long before the executives are willing to do anything about it. And now, those employees can even profit from this knowledge.  The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law on July 21, 2010, includes a provision SEC. 21F, called “SECURITIES WHISTLEBLOWER INCENTIVES AND PROTECTION”. This provision looks to incent whistleblowers with an award of 10% to 30% of the monetary sanction over $1 million.  Therefore, if one were to take the average cost of the top six most recent FCPA settlements and multiply by the lowest award, it would means a $47 million compensatory windfall to the employee who blows the whistle on these bosses.

The FDIC book on the S&L scandal suggests that total FDIC recovery from 1986 through 1996 from professional liability suits was $5.1 billion (outside counsel costs were $1 billion – ie a significant incentive for lawsuits), with $1.3 billion of that coming from D&O claims, and, surprisingly, only $300 million from fidelity bond insurers. The account does not specifically say that the D&O recovery was from insurance policies, but there is no doubt that these insured losses were material to the insurance industry.

In those days, Insured vs. Insured exclusions, and trustee/regulator exclusions and limited severability were much more common in the D&O policy. And, the policies were not as heavily extended to cover loss of the corporate entity, and other parties and matters, as they are today. Also unique to that period was the length of time that D&O insurers had to prepare for potential loss. A noticeable uptick in bank failures was identifiable as early as 1982, but the actual assets losses and deposit insurance losses were not material until 1988.  The period of 1997 through 2007 saw so few bank failures that the slate was wiped clean as if the past never existed. But this time, the asset losses and deposit insurance losses, which, in the 1980’s took seven years to develop, happened in one year. And these losses occurred on the basis of only the modest increase in the number of banks that the FDIC, Fed, Treasury and the OCC have so far made public.

Therefore, with the speed of the recent downturn, the larger average size of the failed banks, the broader policy wordings (more coverage for the corporate entity), and the resources of plaintiff counsel, it might ultimately be impossible to compare the S&L debacle with the GFC.

NERA Economic Consulting released their “Failed Bank Litigation Report” in August 2010, providing a lot of details comparing and contrasting the S&L with recent bank failures, including the resulting D&O and Professional Liability litigation. The first part of the report presents statistics on recent bank failures and the characteristics of their assets, loan portfolios and performance relative to banks that have not failed.  The remainder of the report discusses failure factors and litigation in both periods.

This becomes an even more interesting having read Recovery Partners’ blog entitled “Hubris Meets Nemesis”, which estimates that “…the number of insolvent and/or severely impaired banks in the US to be well over 2000 institutions”, and goes on to point out that the suspension of FASB 157 (“the abolition of “mark-to market” accounting”)  and the failure to activate the Prompt Corrective Action Law. is hiding the true extent of the deterioration in bank balance sheets in the US.  If this analysis is in the ballpark, that will mean that the GFC hit in the US will vastly eclipse the losses from the S&L scandal. Of the 2,912 bank failures from 1980 to 1994, many were private and a lot smaller than the average failure today. It has been suggested that the scandal crisis cost over $150 billion and represented 3% of US GDP. Today, $150 billion is the cost to ‘bailout’ one insurer.  According to the DandO Diary blog, there have been 118 bank failures in 2010, and 165 in two full previous years. Recovery Partners estimates that the Deposit Insurance Fund losses from the GFC are currently in the range of some $500 to $700 billion. See also Chris Whalen’s Institutional Risk Analytics website for similar views on this issue.

The FDIC is starting to sue failed bank directors and outside professionals. FDIC filed two separate lawsuits in the Northern District of Georgia against outside law firms for the failed Integrity Bank of Alpharetta, Georgia. FDIC filed a separate suit against former directors and officers of Integrity Bank. They provide an updated list of failed banks on their website, and a separate list of authorized suits against individual directors and officers.

FDIC litigation in the S&L period was the primary source of litigation. Today the follow-on claims in private litigation by investors and creditors, and criminal proceeding by the DoJ, are very creative in order to avoid FDIC priorities and onerous pleading requirements (scienter hurdle of 10(b)-5.) This could mean that private litigation could cause even more “insured” loss than the FDIC. The “Failed Banks” topic section of the DandO Diary, provides significant detail and resources on the primary claims, third party professional claims, and on follow-on civil litigation.

The Canadians in this group are not insulated from this issue. A majority of the market share of D&O insurance premium written in this country is by insurers who are exposed to US claims. Even if they are not directly writing Bank D&O policies, bank failures affect the lawyers, accountants, pension and investment fund investors, and the ‘bricks, clicks and mortar’ companies who rely on these banks.  There has been a flight to safety for insurers, and that is why we have more than 27 companies writing directors’ and officers’ liability insurance in Canada. Every one of theses firms will have difficulty avoiding the direct and/or reinsurance costs of US losses in spite of the fact that insurance companies typically spread theor risks across all of their insureds, whether these insureds are inter-listed, large public, private or non-profit companies.

In addition to the direct and indirect US exposures, Canada is seeing a material change in homegrown loss experience. The decision in the IMAX class action securities case, was a denial of the defendant’s motion for leave to appeal the K.van Rensburg J. decision to certify class proceedings. We all know what happens to settlement amounts when a court decision goes in favour of the plaintiff class. The underlying securities litigation commenced September 20, 2006, when Siskinds LLP,  and Stutts, Strosberg LLP, brought their case alleging misrepresentation and breach of duty of care. This was the first case to be brought under Ontario’s new, at the time, “Bill 198”, aka, part XXIII.1 of the Ontario Securities Act (the “Act”), section 138.3, which provides a statutory cause of action for secondary market misrepresentation.

The insurance implication is that the IMAX 2005 information circular listed a D&O policy with a $70 million limit of liability. The circular does not provide a lot of detail, and I am not privy to any inside information, but it does say they had a split deductible of $100,000 “for each claim under the policy other than claims made under U.S. securities law as to which a deductible of $500,000 applies”, and paid an annual premium of $962,240.

There is no regulation of D&O or E&O policy wordings in Canada, and there are hundreds of versions of policy wordings, applications and endorsements that can mean the difference between coverage and personal financial loss. In the IMAX case, the split deductible (and the level of premium) would suggest that the policy provided at least some level of coverage for the separate and distinct loss of the corporate entity. If this policy structure, or an undisclosed policy, did not include a separate limit of liability for individual directors and officers, and their non-indemnified claims, then this $70 million is subject to erosion or even full exhaustion by loss incurred by the corporation.

Unfortunately, most directors and officers make a critical assumption that their D&O policy is designed to cover their personal liability. For many directors and executives, this “sharing of limits” problem is only identified after a lawsuit has been launched. The confusion is that this extension is marketed as “securities coverage”, which can be misleading to the individual directors. Some insurance brokers have sold this coverage by suggesting it is the only way to get coverage for claims brought by shareholders. Such a statement is absolutely false. The traditional D&O policy was always meant to apply to claims brought by shareholders, but only those claims brought against individual insured persons, not those brought against the corporation. 

Much more information on Canadian securities class actions can be found in the NERA report, here.

With a relatively small premium base, when compared with the personal and commercial property and casualty market, the specialty casualty insurance marketplace can be materially affected by isolated industry events. Even within this isolated industry (if you can call US Banks an isolated industry) there was a significant historical learning opportunity. With the degree of correlation between contributing factors of the S&L event and the recent bank failures, it is not a stretch to suggest the S&L learning opportunity was completely ignored by far too many decision makers.

If the horse has already left the barn, (which, based on D&O losses to date, has not been determined), then there are two things to do: First, identify and mitigate the current and ongoing risks of this event; and then identify the contributing factors (and people) and take appropriate notice and initiate action, so the market can retain this information and use it to avoid similar situations in the future.

Based on, 1) larger bank asset losses, 2) larger FDIC losses, 3) higher D&O policy limits and broader wordings, 4) deeper pockets in the executive ranks, 5) a new profit incentive to blow the whistle to regulators and the media (and not report concerns to the audit committee and independent board members), 6) the motivation of significant plaintiff lawyer contingency damage awards, and 7) an increase in follow-on civil litigation, insured losses will increase and the risk of D&O and Professional Liability insurance premium increases and coverage limitations is therefore extremely material.

Policy expiry dates, market swings and claims rush forward very quickly. Therefore, timing is crucial. All directors, executives, officers, compliance and legal staff, and other outside professionals should be doing the following:

1)             Request a personal contractual indemnity agreement from the corporation or partnership. Indemnification provisions are built into the Canadian Business Corporations Act, the Ontario Business Corporations Act, many corporate by-laws, and into most of industry specific acts, but, they are not all created equal, and none of them are as good as a well vetted individual contractual indemnity;

2)             Recognize that D&O insurance is not a panacea. It should not be a priority over good commercial general liability, property or operation specific products, like professional liability, errors and omissions liability (“E&O”), environmental, fidelity/crime, and cyber/media/privacy insurance policies.  D&O is also not a priority over good governance, risk management and compliance (GRC) activities;

3)             Know the expiry dates of all policies. Notice I did not say renewal dates, because a D&O/Fidelity/E&O renewal is never guaranteed;

4)             Know your “notice” obligations and opportunities to report claims and “circumstances” to the insurers and trigger your current policy for future loss (no matter when that claim is eventually launched;

5)             Have your broker identify all areas of “limits sharing” within your policies. Limit sharing is very sneaky, because it is not isolated to an insuring agreement; it can be found in the applications (which forms part of the policy,) exclusions, allocation provisions, severability provisions, and even in the definitions;

6)             Treat the D&O purchase decision as it being based on the limit liability, not on the insurance premium. The limit of liability has, or should have, a value that is material to the corporation, often the premium does not. Even for a small non-profit, it is a one or two million dollar decision; for a small publicly traded company it is a five to twenty five million dollar decision; and for a large public company it can be a $100 million decision. The purchase decision deserves this level of attention; and,

7)             Examine the skill, ability and independence of your broker (not just your brokerage.) There are far too many brokers who are passing themselves off as experienced, when in fact they have limited or no direct experience with D&O policies and claims. There are also many brokers who marketed (even convince) themselves they are independent, even when they owned by, or have a material debt or non-standard remuneration agreement with, an insurance company. It is therefore appropriate to, a) request full disclosure of ownership and all potential conflicts of interest, including any “exclusive insurer” programs, b) ask all brokers to explain to your satisfaction the key issues regarding all coverage options as they relate to your operations, and, c) request of all brokers not approach any insurance markets on your behalf until you have made your choice of broker.

Through aggressive competition among insurance companies and under-educated and overzealous insurance brokers, policies have been “broadened” to such an extent that they are now a possible detriment to the appointment of directors. Claims made against the corporate entity and coverage for non-traditional parties and matters are now fair game under many D&O policies. This level of coverage can be very attractive to aggressive plaintiffs, and their even more attractive to aggressive plaintiff’s lawyers, because a broader policy means a better chance for at least a modest settlement. A modest settlement reduces the down-side risk of pursuing what might be a long-shot chance of discovering a smoking gun that will produce the home run settlement (entire policy limits, plus corporate contribution, plus third party contribution, plus individual director and officer contribution.)  However, there is only one limit of liability that will be shared by all parties for all claims.

We have yet to see how US bank failures will play-out for D&O insurance buyers, but given what we already know, it behooves executives, directors, corporate risk managers and their advisors to meet this issue proactively and forcefully.

This is a guest blog by Greg Shields, a Partner and commercial insurance broker with Mitchell Sandham Insurance Services in Toronto, specializing in D&O, E&O and Fidelity insurance. His blog posts can be found at http://mitchellsandham.wordpress.com/, and he can be reached directly at gshields@mitchellsandham.com, or at 416 862-5626.

 

Posted in Bank Loans, Bankruptcy, Canada, Crisis, Insurance, Loan Losses | No Comments »

Destination Canada

“It is a serious question. We are no longer talking about a single country having a big Depression but the entire world.”      Paul Volcker

Where to turn? Each day we are bombarded by stories of bombings, plagues, genocide, civil war, famine and hardship. On the economic front the available information is increasingly evoking memories of the disaster that is now known as the Great Depression.

Countries that were once regarded as the bulwark of the Postwar Monetary System now seem to be engaging in a high stakes game of chicken: the Fed is actively debasing the dollar; the Bank of England is talking sterling down; the European Central Bank is buying the bonds of Zombie EMU Sovereigns to stave off the collapse of European Banks and destruction of the Euro; and on September 15^th the BoJ carried out one trillion yen worth of FX sales and has threatened a follow on operation. Russia, Brazil, China and other South East Asian Nations are also actively playing the debasement game; even staid old Switzerland has been accumulating FX reserves at a torrid pace.      

There is little confusion over the reasons for this tilt into head-over-heels competitive devaluation. Global demand has shrunk, and all countries are now vying for a slice of a shrinking export pie in order to maintain domestic income, employment and taxation levels. Hence, this outbreak of currency exchange conflicts is bound up with mounting signs that the global economic crisis is systemic, rather than merely cyclical, and a growing pessimism that a genuine recovery is not in the offing.

In addition to general economic malaise many developed countries are experiencing a demographic crisis. Coupled with the fact that of many of these countries have been simply living beyond their means and are now facing debt crises, an adjustment to reality seems inevitable.

In today`s market environment the key question for investors may be rapidly becoming one of capital preservation rather than return maximization. Where do you go when everything seems to becoming apart at the seams?

The Great White North Beckons

Private Investors and risk aware investing institutions could do worse than consider Canada as a destination for their portfolio assets.

Canada’s Financial Institutions are well-capitalized, well managed and well regulated. The economic management being delivered out of Ottawa is very responsible with Mark Carney at the helm of the Bank of Canada and Jim Flaherty as Minister of Finance. Indeed, the Bank of Canada stands out in recent monetary history as one of the few central banks that did not succumb to the blandishments of Helicopter Ben and engage in Quantitative Easing, thus it has avoided the inevitable pollution of its balance sheet with non-traditional assets, and the loss of policy flexibility that the Fed and many other central banks are now facing. 

Canada did experience a form of sub-prime mortgage crisis in 2007 and all of the sub-prime lenders and securitizers went bust and investors lost about $20 billion. But this has already blown over, and at the time it barely registered in terms of impact on GDP.

Public Finances are in great shape. Despite CAD 55 billion of stimulus measures implemented to kick-start the economy, Ottawa’s budget deficit is temporary and therefore the country has no structural deficit. From a government debt management standpoint  the only trouble spots are the finances of Ontario and Quebec, but these are issues of a manageable dimension.

We have the most energy resources of any country in the world, a hugely productive agricultural sector; mining; humungous fresh water resources, leading edge high tech industries, low crime rates and we score very low on the corruption index. We have all the wood, concrete, copper and steel that we could ever possibly need to build homes, factories and skyscrapers. All of the 2008-2009 job losses have been recovered up here. Thus our unemployment rate at just a shade over 7.0% compares most favourably with that of our southern neighbour which on the kindest basis is brushing close to 10%.

Politically we punch above our weight on the international scene, being a long time member of the G-8; the G-20 and about to take up a seat on the UN Security Council. Our men and women of the Armed Forces are extremely highly regarded as probably the best Peacekeeping Forces in the world by both friend and foe alike.

Certainly there are some clouds on the horizon. Household finances are somewhat stretched in sense that the private sector has accumulated a large debt load that will need to be reduced in relation to income. Health care costs continue to weigh on public finances and some reform or user pay option will likely need to be introduced in order to restore sustainability. Another medium term challenge is to re-direct our trade relationships away from the US because that economy is going to be in slow growth mode for the foreseeable future and we don’t want our wagon tied to a sputtering locomotive.

At present the economic numbers are starting to soften in Canada and it looks like the housing market is going for a dump in the near term. No matter, a downbeat economic picture describes the outlook  for pretty much most developed economies at present. On a relative basis, as noted above Canada can be expected to outperform because of our strong fundamentals, robust finances and exemplary economic stewardship. All countries will have to weather the coming economic challenges and uncertainties, including having to cope with the consequences of the monetary policy experiment being run by Helicopter Ben. Some countries will fail to manage their affiars and possibly lose a measure of independance as a result,  most countries  will suffer additional great hardships and privations. Canada, for its part promises to continue as an island of relative stability in an increasingly hostile and uncertain global economy.

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